Monday, May 19, 2008

How Safe are the GSE's?

Freddie Mac's earnings release from last week created quite a buzz. It was initially viewed as an unmitigated positive, but upon further review, we all realized Freddie's accounting is too opaque to draw any reasonable conclusions.

I do feel that there have been some mischaracterizations of reality around the blogosphere, and I thought Accrued Interest could help shed a little light on the situation. So here is a little Q&A on what this development really means to real investors.

Q: Freddie Mac is actually insolvent, right? I heard they had negative net worth.

A: If you define insolvency as negative net worth on paper, then yes. I don't know to whom such a calculation is relevant. Its a quirky statistic that is emblematic of their recent woes. But it isn't relevant to investment valuation.

Q: But if they are insolvent, that would mean the tax payers might have to bail them out!

A: Tax payers will have to bail out the GSE's if it comes to that. I have no doubt about that. But it only will come to that if the GSE's cannot fulfill their function as liquidity providers to mortgage originators. Right now that isn't a problem, despite the negative net worth.

One could argue that the GSE's are only able to fulfill that liquidity function because of implicit government support. I think that's probably true. But if you believe that, then it wouldn't matter how much money the GSE's lost as long as the market believed in their government support.

Q: Freddie Mac's senior debt rating is still AAA, which is about as much bullshit as Ambac. How can these guys keep losing money quarter after quarter and retain that rating?

Actually, through the miracle of subordination, debt holders are probably relatively safe, even without government support. To be sure, there is no way either GSE would earn a AAA rating without the implied government support. But consider the debt/asset situation at Freddie Mac:

Total Assets: $786 billion (eliminating their deferred tax asset)
Total Senior Debt: $755 billion
Total Sub/Preferred Equity: $19 billion

So in order for senior liabilities to be greater than assets, the asset pool would have to decline by about 4%. Freddie Mac's credit loss was at a 12bps rate in Q1 and their forecast is 18bps in 2008 and 20-25bps in 2009. Take the company's estimates with whatever brand of Kosher Salt you like, but consider the odds of them being wrong by a factor of 16. (See note at the end of this post)

Q: You just want to be lied to, don't you? How can you trust any of their asset valuations anyway? I heard its all Level 3 assets!

A: They have $157 billion in Level 3 assets.

Q: Every one on my message board knows that Level 3 assets are toxic waste. That would more than make up your 4%!

A: First of all, the concept of Level 1, 2, and 3 assets stems from FAS 157, which is summarized here for those who like primary sources. The idea was to categorize the means by which assets have been valued by management. Level 3 assets are those that have been priced using "unobservable" inputs.

Q: Aha! Unobservable means mark-to-make-believe!

A: Part of requiring the Level 3 disclosure was to allow investors to consider how much they want to trust asset valuations based on models, especially in a market like this. So if you want to discount the valuation of Level 3 assets, the new disclosure allows you to do so.

Q: OK, so how much should I discount the assets? 100% or just 80%?

A: Unfortunately, there is some debate as to what constitutes an unobservable input. In Freddie Mac's case, they had classically valued their ABS portfolio by getting dealer quotes, and therefore believed that suggested a Level 2 designation. However given the wide variance in dealer quotes, Freddie decided to move the assets to Level 3. I'd think of it this way: if the model inputs being used by dealers were "observable either directly or indirectly" (Level 2) it stands to reason that the various dealers would have similar observations, and thus similar prices. Since they didn't have similar prices, you have to conclude the model inputs are not readily observable.

Q: Sounds like you are leaning toward 100%.

A: The reality of the bond world isn't that simple. The fact is that the overwhelming majority of fixed income instruments rarely trade. Therefore almost all bonds held on any company's balance sheet are valued by a model. For that matter, bonds that are held in your run-of-the-mill investment-grade mutual fund are similarly valued by model. One could make a case that a very wide swath of bonds are valued with "unobservable" inputs.

For example, there are 1,082 tax-exempt municipals bonds rated below investment-grade by Moody's. Of these, only 307 have traded any time this year. Now I grant that there is some correlation among junk-rated muni spreads, but how comfortable would you feel about the valuation of some struggling nursing home deal in Wisconsin by examining the trading level of a convention center in Texas? According to the FASB "Adjustments to Level 2 inputs that are asset specific... might render the measurement a Level 3 measurement." Sounds like the valuation of rarely traded municipals would fall into Level 3.

Q: But Freddie Mac is getting their quotes from dealers! And Freddie Mac is one of the 5 or so best accounts to have as a bond salesman. The dealer firm is obviously biased.

A: Granted. But what's the alternative? You are talking about positions for which there is no trading market. The best you can do is ask someone what they might pay for it, and value it that way. Its biased, but the alternative would be for Freddie Mac to create their own model. Can you imagine the outrage on the interweb if that's how they valued their positions?

Besides, I'd bet that Freddie Mac thought that getting quotes from dealers was the only way to avoid Level 3 designation. Asking for a theoretical bid from a dealer could reasonably be considered an "observable input" thus allowing a Level 2 categorization. Only when it became obvious that the dealer community had no idea what to bid did Freddie move the assets to Level 3 designation.

Q: So when the dealer quotes were too low, Freddie changed their methodology! Its Enron all over again!

A: Actually Freddie Mac didn't change their methodology, merely moved their ABS portfolio into Level 3. They always valued their positions with dealer quotes. You are better off not obsessing over the Level 3 assets themselves, but rather the fact that no one seems to know what Freddie's assets are actually worth.

Q: I still don't trust their accounting.

A: Neither do I. Its clear that derivative accounting according to GAAP doesn't reflect the reality of Fannie Mae or Freddie Mac's business. My best guess is that Freddie's recent figures were aided in a non-economic way by accounting practices. But who knows? I really don't feel like I have a good handle on it.

And guess what? I'd feel exactly the same way if they had zero Level 3 assets.

So what's the point here? Any financial firm involved in fixed income securities and related derivatives is likely to have significant Level 3 assets. Reflexively assuming this means the firm is involved in shady securities is lazy analysis. The hysteria over Freddie's Level 3 assets is misplaced. Thoughtful analysis as to why Freddie Mac felt compelled to move their assets into Level 3 is what's needed. Its a little spooky to consider that Freddie Mac can't get a good value on their securities, that their dealer evaluations varied so much. That's the more important point in analyzing Freddie's balance sheet.

Note
This calculation as presented here is not entirely accurate, primarily because I erroneously equated the credit loss percentage as if it were a percentage of assets, but in fact it is a percentage of Freddie Mac's guarantee portfolio. That's what I get for trying to put together a back-of-the-envelope example, but there is no excuse for publishing something like this.

I probably shouldn't have included the example at all, as it was a very simplistic calculation, and honestly, it probably took away from my bigger point that FRE and FNM's accounting is a mystery. I mean, I tried to argue the opacity of their books, then I used their books to make a point.

On top of that, I quoted their credit loss percentage of their guarantee portfolio vs. their asset base, which was totally wrong on my part. My idea was to value the company's debt from an asset liquidation perspective but the introduction of the credit loss percentage wasn't the right metric.

The more accurate way to look at it is that the company expects $3.1 billion in credit losses in 2008 vs. the gap between assets and debt of $31 billion. So if you imagine credit losses as requiring cash to flow out the door, we'd need 10x the 2008 credit loss level (with no positive cash flow in the interim) for the debt/asset ratio to fall below 1.

Now that could be coupled with losses in their investment portfolio. That's an area that's difficult to forecast, because I just don't know whether they've properly written down their assets or not.

29 comments:

Anonymous said...

So in short:

Without government backing, they don't have AAA funding and would not stay in business.

Without government allowing them to use accounting slight of hand, they would be closed up right away.

FHLMC has three times as much Level 3 assets as they do equity.

Both GSEs are levered by amounts that no private entity could get away with.

... or to be really brief, GSEs remain in business because Hugo Chavez is running the country and he says so.

Back when the U.S. was run by capitalists, we didn't have to play these games. Our government wasn't hopelessly buried in debt. And our children could look forward to a higher standard of living than their parents.

I want to go back to capitalism.

Anonymous said...

Sure, we all do, anyone with eyes to see, that is. Ain't gonna happen unless we leave Iraq, quit funding Israel, do a long list of deregulation. I don't expect it. Which means making money like scavangers picking over the bones of not-quite-dead but terminally sick empire.

AI: thanks, good job on explaining the GSE situation.

Accrued Interest said...

There is no doubt the GSE's couldn't have a AAA rating without government support. I wouldn't go so far as to say they'd be out of business. But then again, they would probably have big time liquidity problems w/o the impicit govt backing.

Of course, without the govt backing, they'd never have gotten so big... for better or worse, the world is very different for having FRE and FNM.

As a libertarian, I'm philosophically opposed to the GSE's. I'd love to see them phased out of existence, or at least, figure a way to phase out the implicit govt backing.

But that just isn't going to happen. My time is better spend considering the world we actually live in rather than the world I wished we lived in.

JR said...

I understand that the problem is not that there is implicit government backing of the gse's, it is what it is, but that the quality of those assets is indeterminate. Okay, I'm hip, but how does it get solved? It seems that nobody is revealing any results of significant digging into these assets (securitized pools of loans, right?). It has already been proven that much of this stuff hasn't followed historical patterns and that new models need to be developed to value these things. Is anybody doing this or are there just a bunch of deer in headlights hoping for the best? I think that is why you used "evaluations" rather than "valuations," implying that nobody is apparently trying to solve the problem from bottom-up.

Anonymous said...

FRE and FNMA remain solvent as long as the MI's do. The "first loss position" players must go down first.

Interesting that as much as we whine about the "implicit guarantee" that these two GSE's get, the current political solution is to vastly expand FHA with an "explicit guarantee" of the US Gov. Jumbo and SubPrime FHA - sowing the seeds of the NEXT Housing crisis.

jimi

Anonymous said...

For every asset there is a price. If GSE's have a large inventory of Level 3 notes, they should randomly sell some to get an evaluation. Mark to market seems better than mark to fiction.

PNL4LYFE said...

Marking to an actual bid would be great in theory, but think about the situation. You have a seller that must sell a small amount. You have potential buyers who KNOW that the seller must sell. What is their incentive to bid what they think is the "fair" price? They can throw out a low bid in the hope (or fear..) of getting hit there. For hard-to-value assets, the problem is even worse because bidders need an even larger margin of safety to protect themselves. You will determine a true market price, but in some cases this won't be the best estimate of fair value.

jult52 said...

AI: Accepting that the GSEs are able to maintain their current level of assets only because of the implicit Fed guarantee, what do you rate their odds of being forced to decrease their asset base? This inability could be caused by any number of factors. I am more interested in the macroeconomic effects of such an asset decrease than in the effects on the GSE shareholders. If you feel like this subject deserves a separate post, I understand. Thanks in advance.

Accrued Interest said...

I don't think the GSE's contract their asset base any time soon, if you mean in terms of their gtd business. That would be contrary to what they've been publically saying. Plus OFHEO is encouraging them to grow, in no small part to help with the housing problem.

They could allow their investment portfolio to run off a bit. That would likely cause modest spread widening in the MBS world.

There does seem to be a risk that FHA supplants some of FRE and FNM's traditional business lines. But that wouldn't have a clear macro impact that I can think of.

Accrued Interest said...

As far as marking to an actual bid, I think they would claim that's what they are doing. Its BS as we all know it, but you can't force them to sell assets.

Besides, whats to stop them from finding the best foreclosure in America and selling that one, then marking everything off it?

Nick said...

Can you speculate at all on the end-game for the GSE's, and how far out that might be? That is, they have a certain amount of assets, and certain payments they need to make to pay off failing debts. Given their current assets, current foreclosure rates, and assuming all the level 3 assets default eventually (but at the normal rate), when must they have a bailout to keep going? It looked like about a year to me, but I could be reading their obfuscated numbers very wrong. Any insight/analysis?

Livingston said...

You wrote" Freddie Mac's credit loss was at a 12bps rate in Q1 and their forecast is 18bps in 2008 and 20-25bps in 2009. Take the company's estimates with whatever brand of Kosher Salt you like, but consider the odds of them being wrong by a factor of 16." This is not true! The loss rate that you quote are for their guarantee business. But the assets that you quote are for their portfolio holdings. They are just very different things because their portfolio is far worse than their guarantee obligations. Apples and oranges.

Wagner2626 said...

I am not quite sure what the point of the post is. Are you trying to say that the GSEs are a good equity investment? A good debt investment? Maybe a good preferred investment?

I happen to believe that the debt is fine and the equity is way overvalued even after 60+% declines. Here are some other issues (some of these have already been mentioned in the preceeding posts):

Large exposures to the mortgage insurers. Should any of the majors fail, they would cause direct losses in the equity of either FNM or FRE.

Exposures to shaky servicers: this is NOT direct exposure, but CFC is the largest servicer for FNM and the larges originator. Should the BAC/CFC deal fall apart, I believe that CFC would likely fail. Replacing a large servicer would be difficult and the inevitible problems with payments being missed, reduced collections on foreclosure ect... All of which would increase losses in the guaranteed portfolio. Finally any of the mortgages that did not conform that FNM or FRE could put back to the originator, wouldhave to pass by the bankruptcy judge.

There are other servicers/orginators that are in trouble: ResCap and IndyMac to name two.

In the end the govt will step in to bail out bondholders, but you cannot say the same for the equity.

Fannie said something on the last call that the assets that they are aquireringnow would "provide for a feast in the future." To the degree that the liquidty part of the crunch is over, they may find that they have competetion again.

Accrued Interest said...

Wagner: I hear the bit about mtg insurers a lot. And I'm not claiming they don't have exposure. But in my mind its more like a municipal portfolio and the monolines. You don't actually have any losses until the insured security defaults.

Now they'd obviously have to increase their loss reserve, but there wouldn't be any immediate cash losses.

I really hate that I'm defending the GSE's but I feel like there is a lot of misinformation out there.

Anonymous said...

"I really hate that I'm defending the GSE's but I feel like there is a lot of misinformation out there."

This is the unfortunate part of the banks not telling the truth. Unless, you have transparency, trust and credibility back to the investment community, then there's gonna be a lot of misinformation. Are all these AAA MBS as safe as treasuries? Maybe they are since our Fed is taking trash for cash.

Anonymous said...

AI: I really hate that I'm defending the GSE's but I feel like there is a lot of misinformation out there.

An obvious (and easily foreseeable) consequence of Bernanke's policies. Bernanke didn't really bail out Bear, so much as he bailed out the whole securitization industry.

We all know that there are massive losses still remaining-- we just aren't sure who owns them. Pretending like its "just a liquidity" problem only serves to undermine the Fed's credibility (that plus constant claims that inflation is moderating even as CPI keeps going up).

Part of the "liquidity" problem is a fear of the unknown. Since we don't know who is insolvent, we have to assume the worst about all banks until proven otherwise.

Allowing insolvent institutions to get financing only delays the day of reckoning -- it means we have to wait that much longer before we get true price discovery.

Are the GSE's insolvent? I don't think AI has any more clue than the CEO of FNMA. You are all just pulling an opinion out of the wind (to be gentle about it).

And now the GSEs are going to lever up even more? This is the same group that fired Franklin Raines because the accounting was so blurry that no one knew what was actually happening -- Raines "smoothed" out any meaningful information.

Allow 97% LTV? Home prices cannot fall 3%? Come on, please.

It really doesn't help when AI gives us blank and unsupported assurances that the GSEs are OK. We are pretty sure they are not -- the only question is whether they are damaged enough (yet) that they cannot grow there way back to health using the Treasury's implied credit line.

At some point, taxpayers are going to have to bail these govt SIVs out-- its a question of when, not if.

charles s said...

AI,

Regarding the implicit government backing of GSE's: I wonder whether one additional piece of supporting data to this claim might be the following fact: The Fed has long bought and sold agency MBS (along with treasuries) from member banks to maintain the fed funds rate. If the Fed's portfolio routinely contains large amounts of agency MBS it must be that there's that implicit backing there, albeit not as big as the US Treasury Dept.'s backing.

Please let me know your thoughts.

Anonymous said...

Charles-- not true.

The Fed owned agency debt itself (obligations of the GSEs) -- but no MBS securities of any kind (not even GSE backed).

Buying MBS securities (or lending against them) is a new thing

Anonymous said...

Is it possible that the Level 2 quotes were/are such a disaster that they could not use
them for public disclosure, thus
it was an easy fix to move them to Level 3 and just make up a number
and put it off for another day. Problem is, what would cause that day to ever happen? What would stop them from hiding it forever?

Anonymous said...

The GSEs are too big for Uncle Sam to rescue. China is going to need to bring money home to pay for the earthquake

Not safe at all.

John D said...

Two suggestions for future post titles, as suited for the occasion:

"At last, we reveal our Level 3 assets."

"Write them down, all of them."

Accrued Interest said...

Charles: Anything related to the TSLF is new, including the MBS pledging. Banks could always use MBS at the discount window, but they could also use much weaker credits as well, so that's no indicator.

Anon on Level2 vs 3: **IF** you believe Freddie Mac, they claimed that they didn't change how they valued the assets, merely what category they put them in. So assuming they aren't lying about that, the valuation levels are the same as they would have been.

Accrued Interest said...

John D: Awesome.

Another thought. Be careful assuming the govt. can't bail out the GSE's because they are too big. Bailouts can take many forms. If they do need a bailout, I'd suspect the govt will just directly gtd their debt. Think Chrysler. It wouldn't automatically create a huge outflow of cash.

Now someone said that all these bailouts just delay the day of reckoning. Maybe, maybe not. I really don't care, because the reality is that if the GSE's get into big trouble, there will be some kind of aid from the govt. Period. For better or for worse, tax payers are married to the GSE's. That's the reality.

Anonymous said...

Your math on the security of senior bond holders doesnt consider the $1.3T in net par outstanding of bond guarantees, which would be senior to senior secured debt holders I believe.

charles s said...


The Fed owned agency debt itself (obligations of the GSEs) -- but no MBS securities of any kind (not even GSE backed).


My bad. But doesn't the fact itself that treasuries are accepted like agency paper lend support to the claim that there's implicit backing to GSE's?

charles s said...

meant to say the opposite, that agency paper is accepted like treasuries ...

Accrued Interest said...

By the way, I feel like I have to address the critcism of my simple asset/debt ratio analysis.

I probably shouldn't have included this, as it was a very back-of-the-envelope calculation, and honestly, it probably took away from my bigger point that FRE and FNM's accounting is a mystery. I mean, I tried to argue the opacity of their books, then I used their books to make a point.

On top of that, I quoted their credit loss percentage of their guarantee portfolio vs. their asset base, which was totally wrong on my part. My idea was to value the company's debt from an asset liquidation perspectivem but the introduction of the credit loss percentage wasn't the right metric.

The more accurate way to look at it is that the company expects $3.1 billion in credit losses in 2008 vs. the gap between assets and debt of $31 billion. So if you imagine credit losses as requiring cash to flow out the door, we'd need 10x the 2008 credit loss level (with no positive cash flow in the interim) for the debt/asset ratio to fall below 1.

Now that could be coupled with losses in their investment portfolio. That's an area thats difficult to forecast, because I just don't know whether they've properly written down their assets or not.

P.G. said...

A true AAA credit quality or not, I still feel very comfortable investing in GSEs. The government has no choice but to bail them out if they go under. What else are you going to buy as far as safe bonds are concerned. All the municipalties that I've delt with have 30 to 70% of their portfolios invested in Fanny or Freddy. I used to sell to some larger cities $50 million blocks of GSE bonds. They can't afford to lose that and still be able to pay on their GO bonds. So our muni bonds would probably go into default also. Most of us can kiss our pension plans goodby if they go under. Bear stearns is a small fry compared to the GSEs and the government bailed them out. I guess that's why some of us refer to Fanny and Freddy as "implied full faith and credit of the U.S. government."

Thebest323 said...

GSE debt has been attractive to investors, as it pays a higher yield than US Treasuries despite the perception that GSEs are just as safe as the US government—the (not so unreasonable) presumption being that the government would step in to bail them out if trouble hit.

-Bail y


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